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Brazil's Deepening Crisis (Int'l Edition)

March 21, 1999

International -- Latin American Cover Story

Brazil's Deepening Crisis (int'l edition)

In a one-room plaster and wood home in a slum in Recife, a city 2,500 kilometers north of Sao Paulo, Expedita Monteiro frowns as she discusses her fears about Brazil's growing economic turmoil. Monteiro makes less than $100 a month as a maid for two local doctors, and she washes laundry on the side. With the economy slowing and prices rising, she's worried that she won't be able to afford the beans and rice to feed herself and her three children. "I remember from the past what can happen," she says.

From poor neighborhoods to streetcorner merchants to giant multinationals, Brazilians are hunkering down for what could be the country's most painful economic period since the debt crisis of the 1980s. Five years after President Fernando Henrique Cardoso conquered hyperinflation with a brand-new currency, the real, Brazil's great economic experiment looks close to unraveling.

Nearly all the country's economic indicators are going haywire. With a 35% plunge in the real since Cardoso allowed it to float freely on foreign exchange markets in January, inflation is soaring. To shore up the currency, the government has been hiking interest rates sharply. As a result, the country is already plunging into deep recession, with the economy expected to shrink by 3% to 6% this year. Soaring rates mean Brazil even runs the risk of eventually defaulting on its ballooning $170 billion in domestic debt. And although the International Monetary Fund announced a $4.9 billion loan for Brazil on Mar. 8--the latest tranche of a $41.5 billion package agreed to last November--the funds are unlikely to reverse for long the flagging confidence in Brazil's currency and economy.

At stake is nothing less than the hard-fought gains Brazil has made since it began to open its economy in the early 1990s. Cardoso's anti-inflation drive paved the way for an estimated 30 million impoverished Brazilians to save part of their incomes to buy consumer goods. Economic stability spurred multinationals from General Motors Corp. to Wal-Mart Stores Inc. to invest $53 billion in Brazil from 1996 to 1998, giving them a huge stake in the country's success. As trade barriers came down, long-protected Brazilian businesses whipped themselves into shape to compete with a flood of cheap imports. And Cardoso privatized scores of state-controlled companies, from banks to the phone system.DRAGGED DOWN. Now inflation threatens to turn back the clock. Already in February, prices spiked upward by 3.6%--an annualized rate of 53%. If Cardoso cannot control prices, Brazil will find itself "going back to a very different kind of economic model," says Albert Fishlow, a Latin America expert at the Council on Foreign Relations in New York.

Inflation rates of 50% to 60% or more could again become the norm. That would spur workers to demand wage indexation--a tool used in the early 1990s to keep Brazilian salaries in line with inflation. In a world of spiraling prices, local companies would be tempted to play speculative financial games, rather than focus on bolstering competitiveness. And inflation would dash the aspirations of millions of lower-income Brazilians to join the middle class as consumers.

The tumult in Brazil is already dragging down Argentina, which in recent years has sent nearly a third of its exports to its larger neighbor. Brazil's devaluation destroyed the competitiveness of Argentine exports overnight. Auto exports slumped more than 20% in January, as leading manufacturers such as Ford, Fiat, and Renault announced layoffs. As a result, economists who only six months ago expected Argentina's gross domestic product to rise by 5% in 1999 now say it will shrink by 2% to 3%.

Largely because of Brazil, J.P. Morgan predicts that Latin America's economy this year will slump by 2.3%, compared with growth of 2.3% last year. The downturn deals a blow not only to local companies but to U.S. and other foreign corporations that were banking on the region's growing markets as recently as last fall. Moreover, if Brazil spins out of control, forcing the government to default on domestic or foreign debt, foreign banks active in the country--such as Citigroup--could take a hit.

Financial volatility is also sure to put a strain on Mercosur, the regional trade group led by Argentina and Brazil. Despite the gush of cheap imports into Argentina, Buenos Aires is pledging to keep trade routes open. But Argentine analysts believe that the bloc will not be able to withstand many currency swings as big as Brazil's 35% real devaluation. "If currencies move abruptly by more than 10%, Mercosur isn't going to work," says Buenos Aires economist Carlos Rivas. Trade tensions would also weaken Mercosur's hand in planned talks with the U.S. for a hemisphere-wide trade pact.LITTLE ROOM. Cardoso and his new central bank chief, Arminio Fraga, are struggling to prevent such a profound economic reversal. The government says it has no intention of defaulting. Fraga and Cardoso are also betting that weak domestic demand will discourage Brazilian companies from raising prices. To fight inflation, on his first day on the job on Mar. 4, Fraga increased overnight interest rates by six points, to 45%. The real strengthened 4% the next day. But every one-percentage-point hike in rates lifts the cost of servicing the government's overall debt by $2 billion a year. Some $31 billion in domestic debt matures just in March and April.

Brazilian companies and people are increasingly feeling the pain. Outside the Sao Paulo headquarters of the confederation of skilled-workers unions, Forca Sindical, the line of jobseekers stretches around three city blocks. Unemployment in Brazil is running at 8%--a 15-year high--and in Sao Paulo, it has soared to close to 20%.

That's why Brazil's economic dilemma is the most serious test yet of Cardoso's four-year presidency. The best he can hope for is a short--albeit deep--recession. If Cardoso makes all the right moves over the next few months, economists say, Brazil could come out of its crisis much as Mexico emerged from the aftermath of its 1994 peso devaluation. By the end of this year, in this optimistic scenario, Brazil could emerge from recession to renewed growth with a stabilized real.

But to do that, Cardoso must take tough decisions now, and the markets must back him every step of the way. He must convince his unruly Congress and Brazil's 27 states, many of which are run by his political opponents, that severe austerity measures are necessary to keep a deep recession from turning into economic chaos. At the same time, Cardoso must persuade the states to cough up payments on $50 billion in debts owed to the federal government.

Despite opposition from working-class Brazilians and business leaders, Cardoso is toeing the IMF line, wholeheartedly embracing its prescription of higher interest rates and budget cuts. Congress has already approved key tax increases, and Cardoso recently announced an additional $1.8 billion in spending cuts and tax hikes. By the end of March, Congress is expected to vote on a financial transactions tax that could raise $4.6 billion for the government by yearend.

Many believe Cardoso will have to go much further to restore credibility to the tattered real. He'll have to defy opposition to push through drastic tax reform, slashing through Brazil's complex web of levies, and eventually introduce a private pension system. The country might also have to sell off major stakes in companies still held by the state, such as oil company Petrobras or Banco do Brasil.

Many business leaders criticize Cardoso for not taking such radical moves to fix the country's deeper economic problems a year ago, before the contagion from Russia dealt a blow to Brazil. Back then, the country had $75 billion in reserves, and a record $26 billion in foreign investment poured into it in 1998. But Cardoso turned his attention to getting reelected to a second term. "Brazil missed a window of opportunity to move forward, and it's paying the price," says Hermann H. Wever, president of the Brazilian unit of Germany's Siemens.

Now, faced with continued uncertainty about the real, companies are hedging their bets. They are holding off on key decisions until they see whether the real stabilizes. Ernesto Teixeira Weber, chief executive of petrochemical producer Polibrasil, which exports about 15% of its $400 million in annual sales of polypropylene, is figuring the currency will stay volatile until at least April. So he isn't setting export and production targets until then. "We are in the eye of a hurricane, waiting for it to pass," he says in his office at Polibrasil's plant 35 kilometers southeast of Sao Paulo.PENT-UP DEMAND. Other executives are openly worrying about runaway inflation--or they are jacking up prices themselves. Sadia Concordia, Brazil's largest producer of processed foods, says it will raise prices by up to 18% because of the higher cost of imported raw materials. Brazil's airlines, including national carrier Varig, plan to raise fares by 20% or more. Sao Paulo cellular phone operator BCP, a consortium led by BellSouth Corp., believes it can still thrive in a downturn because of the pent-up demand for phone lines. But the company's one fear is an outbreak of price hikes, which would dampen demand from new customers. "We could handle a little inflation, but hyperinflation would be bad news," says Roberto Peon, president of BCP.

As the reality of recession sinks in, companies across the country are shelving expansion plans. Steelmaker Companhia Siderurgica Nacional, for example, is suspending construction of three new steel mills. At processed-foods and poultry producer Perdigao, managers are preparing to slash output of expensive meats, while boosting production of cheaper sausage and bologna if inflation surges. Says Wang Wei Chang, Perdigao's chief financial officer: "These days, you can come up with one business plan in the morning and have to do it over in the afternoon."

Soaring rates are slamming industries heavily dependent on consumer credit for sales. The auto industry, which represents 12% of Brazil's $500 billion GDP, has been particularly hard hit. Auto sales crashed by 50% in February, after falling 21% for all of 1998. Newcomers such as France's Renault, which opened a $1 billion plant in southern Brazil last year, face the daunting task of penetrating a dwindling market.

Even market veteran Ford Motor Co. is struggling. Ford tried to fire 2,800 workers in December but backed off after workers peacefully occupied its plant outside Sao Paulo. The U.S. company still wants to eliminate 2,000 jobs through voluntary retirement, after its sales in Brazil fell by a third last year, to 195,000 units. Volkswagen, meanwhile, is trying to unload its stock of imported models by selling them at prices fixed before the devaluation of the real. And it is taking advantage of the weaker currency by boosting shipments to Mexico. Says Winfried Vahland, vice-president for finance and corporate strategy at Volkswagen in Brazil: "We are learning to export again."

Boosting exports is the one big hope for companies with competitive products that now face slumping sales in Brazil. Until the real was allowed to float in January, Sao Paulo business leaders complained that the currency was grossly overvalued, putting their goods at a disadvantage against cheaper products both at home and abroad. Thanks to the devaluation, "we feel like we've been unshackled," says Siemens' Wever. His company has slashed prices to the U.S. by 8% in a bid to increase exports of electrical power transformers.BIG LOSERS. As other companies follow Siemens' lead, Brazil's exports are expected to rise about 7% this year, to $55 billion, while imports could plummet by 22%, to $45 billion. The rising trade surplus is a rare example of good economic news on Brazil's horizon. Last year, the country had a trade deficit estimated at $6.5 billion. But the surplus would be even higher if Cardoso could regain the credibility of commercial banks and other institutions that have largely cut the flow of trade financing since the end of last year.

However Cardoso plays his cards in the weeks that lie ahead, the big losers will be millions of ordinary Brazilians. Many of them will feel the pressure both of rising prices and joblessness. Like Expedita Monteiro and her family, they are watching and waiting to see if President Cardoso can steer Brazil through the storm.By Ian Katz, with John Kolodziejski, in Sao Paulo and Kelly Kandaele in RecifeReturn to top